No hard landing is expected in China, Merrill's Harris says. (Photo: AP)

Bank of America Merrill Lynch expects the global economy and markets in 2016 will perform a lot like they did this year, with a few exceptions.

The U.S. economy will continue to lead among developed economies while China’s growth continues to falter, though no hard landing is expected and overall global growth will be “slightly disappointing,” says Ethan Harris, co-head of Global Economics Research.

Developed markets will outperform emerging markets, and investment-grade corporate bonds will beat high-yield debt. And the U.S. dollar will continue to strengthen against the euro, Japanese yen and Chinese renminbi, though at a slower pace.

“The U.S. is the exception,” explained Harris at the firm’s “Year Ahead” press event. The U.S. economy is recovering faster than other developed and emerging economies, which is why inflation is starting to pick up here and why the Federal Reserve will raise interest rates in 2016 while Europe and Japan continue to ease monetary policies, according to Harris.

Such central bank “policy divergence” is a key theme in BofA Merrill Lynch’s 2016 outlook, which forecasts tighter monetary policy also from Brazil’s central bank.

Merrill expects the Fed will raise rates 25 basis points three to four times in 2016 following a hike in mid-December. That’s about half the normal pace of a Fed tightening cycle but significant. “One of [the major] central banks is now going to announce ‘we’re out of the emergency room,’“ said Harris.

But nothing is set in stone. The Fed will “only hike as much as the economy and markets can handle,” said Harris. Merrill forecasts 2.5% U.S. GDP growth in 2016, which will drive the unemployment rate down to 4.5% by year-end from its current 5%.

U.S. growth is expected to top growth in Europe and Latin America – which is forecast to decline – but not in Asia, with the exception of Japan. Overall the global economy is expected to grow 3.4%, up slightly from 3.1% in 2015.

Michael Hartnett, chief investment strategist at the firm, said the global economy is experiencing “a very deflationary expansion” and he expects that “low economic growth and low rates will yield pretty low expected returns.” His targets for year-end 2016 include:

  • S&P 500 at 2200 – up about 7% from current levels
  • 10-year U.S. Treasury yield at 2.85% – up from near 2.23% currently
  • 1% federal funds rate

Hartnett also said the Chinese “need to devalue” their currency again next year.

He recommends that investors:

  • Go long the dollar and volatility
  • Choose stocks over bonds
  • Invest in developed markets over emerging markets
  • Favor high-grade corporate debt over high-yield debt

Merrill also forecasts continued weakness in commodities, including oil, due to the strong U.S. dollar – major commodities are priced in dollars – and restrained global growth.

While the official outlook notes that oil prices could rise in the second half of the year if global demand picks up and OPEC oil supplies decline, Harris noted that if oil prices continue to fall, the “downside risks are significant.”

The positive impact for consumers won’t be as great since oil prices have already fallen sharply and U.S. consumers have grown more conservative about their spending, and the negative impact for producers and manufacturers could be substantial, said Harris.  It would add to uncertainties in the market, and businesses would hesitate to invest.